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CIO Blog

By Paul Hrabal, Chief Investment Officer of One Fund

August 17, 2009

80% Of Investors Get It Wrong

In my last post, Stocks Win In The End, I made the case for stocks being historically the best long term investment. Stocks beat all other investment types in the long run, averaging a 10% annual return¹.

The question that follows is, how best to invest in stocks? It's an important question since 80% of investors are getting the answer wrong.

Let's walk through the options when it comes to stocks:

Option #1 – Stock Pick

Research and buy stocks of individual companies that you think will do well in the future. You may be betting you can do a better job than most investors, including professionals that have multimillion dollar research departments and a team of analysts.

Option #2 – Hire Someone To Stock Pick For You

You realize that you don't have the time or knowledge to pick stocks yourself, but you figure a professional money manager should be able to do pretty well. So you either buy stocks based on recommendations from an advisor or you invest in a mutual fund that picks stocks for you.

The problem with option #2, much like the problem with option #1, is that it is very hard to "out pick" the market.

Morningstar, the research company that tracks mutual fund performance, says that 7 out of 10 stock mutual funds fail to beat the overall market each year. And the 3 out of 10 that do beat the market change from year to year.

Why can't even professional money managers beat the overall market average? Partially due to fees and taxes.

Many mutual fund managers buy and sell stocks a lot searching for the best return. The frequent trading costs money. A recent study suggested it could wipe out 10% of the fund's gains.

The average stock mutual fund also charges, according to Morningstar, a management fee of 1.35% of your investment every year. So if you are hoping for a 10% annual return, the fee just ate up 13.5% of your profit. Tack on the trading costs and now almost 25% of the fund's annual return is eaten up.

Finally, all that buying and selling generates capital gains on which investors have to pay taxes each year, further reducing after tax returns.

Option #3 – Buy Everything

Which brings us to the last option, the one I suggest, but the one only 20% of investors follow.

Give up the notion that you or last year's top mutual fund manager can outperform the market. You can't, and they can't, over the long term.

Instead, own the whole stock market to be better diversified and have an opportunity to realize a return that closely matches the overall market. Through an index fund you can buy a piece of nearly all stocks in the market - essentially owning everything. There is no stock picking, so trading costs typically are minimal, which means potential capital gains taxes may be small.

In addition, since an index fund doesn't need all those high priced money managers and research departments to select stocks, the management fee is typically 60-90% less.

A well diversified index fund seeks a return each year that closely matches the overall market. It will typically outperform around 70% of mutual fund managers year after year².

In our Keep It Simple Guide To Investing we present an investment portfolio example which follows this strategy. Download a free copy and consider how this investment approach might meet your needs.

¹ Source: Stocks, bonds, cash: Ibbotson Associates, historical data 1926-2008. Real estate: “The Equity Risk Premium,” Goetzmann and Ibbotson, 2006. Stocks are 80/20 split of U.S. large and small companies, bonds are intermediate term U.S. government bonds, cash is 3 month U.S. Treasury bills.

² “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas" by Laurent Barras, Olivier Scaillet, and Russ Wermer, April 2009, compared 2,076 U.S. open-end stock mutual funds over 32 years from January 1975 to December 2006.

Before investing you should carefully consider the Fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus. Please read the prospectus carefully before you invest.

An investment in the Fund is subject to risk, including the possible loss of principal amount invested. Other Fund risks include asset allocation risk, foreign securities and currency risk, emerging markets risk, small-cap, mid-cap and large-cap risk, trading risk, and turnover risk that can increase Fund expenses and may decrease Fund performance. The Fund is, also, subject to the risks, which can result in higher volatility, associated with the underlying ETFs that comprise this “fund of funds”. Newly organized, actively managed Funds have no trading history and there can be no assurance that active trading markets will be developed or maintained. Brokerage costs will reduce returns. When the Fund invests in Underlying ETFs, in addition to directly bearing the expenses associated with its own operations, it will bear a pro rata portion of the Underlying ETFs’ expenses (including operating costs and management fees). Consequently, an investment in the Fund entails more direct and indirect expenses than a direct investment in the Underlying ETF.

Distributed by Foreside Fund Services, LLC.